What does the interest rate sensitivity of longer term bonds have to do with liquidity preference?

[M Willis]

In the section of chapter 14 that attempts to explain theories for the term structure of interest rates, one theory given is that of liquidity preference.

Contrary to the title, this does not mention the fact that people will typically prefer investments that can be liquidated more quickly. Instead, it talks only about the fact that the price of longer duration bonds is more sensitive to interest rate changes and investors require compensation for the risk posed by this sensitivity.

What does the relationship between the duration of a bond and it’s interest rate sensitivity have to do with investors’ preference for liquidity?

 

[Joe Hook]

Hi,

Liquidity risk is defined as the risk of not having sufficient cash to meet operational needs at all times. Part of this is, as you mention, is the practical conversion into cash. The easier an asset can be sold and converted into cash the more liquid it is. However, the second element is the cash being sufficient. Longer duration bonds are more sensitive to interest rates changes and so there is a greater chance that their prices move and they can no longer be liquidated for a price sufficient to meet operational needs.

I believe this is what the course notes are referring to here.

Joe